Dow and S&P Sell Off a Bit After Reaching Overbought Levels

Last week’s column ended with the statement that “One of these days the market will undergo some sort of selloff,” and this is exactly what happened after the Dow and S&P made new highs during the prior two weeks literally day after day. This all came to an end last Wednesday and Thursday as the Dow underwent its first back-to-back losses since May 14-15, the S&P suffered its worst one-day decline since May 15, the Nasdaq put in its worst performance since May 6 and the Dow Transportation Index had its worst daily showing since April 10.

So what happened to end the upside fun and games? The main reason for the setback was that the volatility index, otherwise known as the VIX, which moves in the opposite direction of the overall market, got down to levels that indicated a very complacent and overbought situation that was in need of some correcting. As an example of how rare a VIX with a reading under 11 is, let it be pointed out that this index with a “10” in front of it has occurred on only 1.8 percent of the days that it has been in existence in its current form since 1990.

This means that the mathematical probabilities of it going higher are significantly greater than the chances of it going lower. Since it moves opposite to the general direction of the stock market, if the VIX now goes higher, then stocks should go lower, and this is exactly what took place last Wednesday and Thursday. As a result of these declines in the major stock averages, the VIX now rose up to the mid-12 area, which then gives stocks room to move up again, which they did modestly both last Friday and on Monday to start this week.

One can point to what are called “fundamental” reasons to explain the selloff from the record highs, and these range from a lower worldwide economic growth forecast from the World Bank to a gain of 2.8 percent, down from their January forecast for 3.2 percent; the defeat of House Majority Leader Eric Cantor in his Virginia Republican primary, which could lead to less willingness of the G.O.P. to compromise on raising the debt ceiling when it comes up for renewal next March; a lower reading for May retail sales which came in at a gain of 0.3 percent when the projection was for an advance of twice that high. But let it also be pointed out that the April number was revised higher up to a gain of 0.5 percent, the fourth straight month of advances and the two months taken together actually showed a better gain than what was originally expected, but never mind; a slight decline in the preliminary June University of Michigan Consumer Sentiment Survey; and finally the big one, namely, the collapse of Iraq into a vicious sectarian civil war that could disrupt oil production in O.P.E.C.’s second-largest producer after Saudi Arabia.

The turmoil in that part of the world resulted in a spike in crude oil prices up to $107 a barrel, their highest level since last September, and this could potentially have a negative effect on consumer spending which makes up 70 percent of G.D.P. On the other hand, let it also be pointed out that the main oil-producing region is in the southern part of that country, which the Islamist extremists have not yet captured and so far it has been reported that supplies have not yet been negatively impacted.

If one looked at all of the ostensibly “negative” stories these past several days, investors should remember that it was only because the market was in such an overbought position due to the low level of the VIX as mentioned above that stocks were vulnerable to some sort of downside adjustment. In other words, if the VIX had been higher, these aforementioned events might have been brushed off as basically non-events.

As an example of how a slightly lower market dealt with more supposedly negative events to begin the week, the major averages ended with slight gains after starting out lower despite the I.M.F. lowering its growth forecast for the U.S. economy down to 2 percent this year from its previous estimate of 2.8 percent in April but it kept next year’s projected growth rate unchanged at 3 percent. At the same time, it added that the Federal Reserve may have to now keep the federal funds rate at its current record low level of between zero to one-quarter percent longer than the mid-2015 time frame that most investors think that they might be raising it. Then there was the potentially negative news that Russia had cut natural gas supplies to Ukraine as they are now demanding pre-payment for further shipments. Finally, the situation in Iraq seemed to have deteriorated over the weekend as the President said that he is now going to send some troops there after emphatically having rejected this possibility last week.

Some better economic news was able to offset this additional negativity, as the June New York State Empire Manufacturing Survey rose by more than forecast, May Industrial Production also showed a stronger than expected gain, as did the June NAHB Housing Market Index.

We have now gone 33 months without an official 10 percent correction in the S&P, the longest such streak since 2007, and for those market historians let it be pointed out that, since 1945, the market has seen this sort of down move an average of 18 months apart.

Finally, this lack of overall volatility is illustrated by the fact that the S&P has not moved by more than one percent for 40 straight sessions since April 16, and this is the longest such streak since 1995. The average daily fluctuation of the S&P this year has been .53 percent, the smallest such intraday changes since December 2006.

Let us hope that this sort of “calm” market movement can continue because it certainly makes it easier for retail investors to move in and out of positions and not become the victims of large and unwarranted changes in stock prices caused by the maneuverings of the so-called “high frequency” traders who just move in and out of stocks for short-term benefits without regard to the fundamentals.